Before analyzing whether Derivative is a boon or bane. Let us start with the definition of Derivatives. Derivatives are financial instruments which derives its value from the underlying. This underlying can be anything as bullion, commodity, stock, or a stock index. Derivatives can be divided into Forwards, Futures, Options and Swaps broadly based on the purpose for which they are going to be used. Derivatives can either be traded over the Counter (OTC) or on an exchange. OTC’s are the one’s which are customized as per the requirements of the two parties and are not tradable in free market while exchange traded are the standardised one’s and are capable of being traded in an exchange. Now let us take an example and look at a simple derivative forward contract.
In this one party is the seller of the contract and the other is the buyer. Let us say the seller is selling gold at a price of Rupees 600. The seller agrees to buy gold 3 months from now at Rupees 610 and both of them get into an agreement. Essentially all the kind of derivatives contract relates to similar kind of agreements between two parties but with slight variations in terms of contract life, tradability and the purpose of the contract. Looking a bit deeper to the above example one can see that the contract is helping the buyer to first of all book an order for a future date by paying a premium to the seller and not the entire money which he would have to pay if he buys the gold today.
The buyer and the seller in a derivatives contract hold the views that the price of the commodity will rise and fall respectively in the future. Now this seems more like a gamble. But people who buy and sell these kinds of contracts do have their sound logic supported by arithmetic and experience. The derivative contracts are widely used to hedge the risk by different institutions or individuals as well.
Using derivative instruments one can earn a huge amount of profit by investing very less money in a very short span of time. But even though people have their logics behind these, one must not discount the fact that derivative is a zero sum game, wherein one person’s lose is another person’s gain. Now people can earn huge amounts of money in a short span of time but they can loose even bigger sums of money. Some of the example’s which can be cited in this regard are:
a. Nick Lesson leading to the downfall of Baring’s bank
b. Jerome Kerviel leading Societe Generale to a loss of $7.2 Billion in futures contract.
Now seeing these examples one can guess the amount of money which one can loose trading in these instruments.
But on the other hand these instruments can help people and organizations make a lot of money, and hedge their risks against the uncertainties, thus helping them to strengthen their financial positions and their bottom lines.
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